Continuing operations

The company’s 2006 performance was the result of a series of actions taken over the last several years to steadily transform the company. The company has divested of businesses that are commoditizing, while investing in targeted acquisitions to continue to build capabilities in higher value areas. The company has also been focused on increasing productivity, to expand margins and improve efficiency. In addition, it has accelerated its move to become a globally integrated company. These actions have resulted in a more balanced mix of businesses and a stronger, more competitive and sustainable global business. The company’s 2006 financial results reflected this improved business model.

The company divested its Personal Computing business on April 30, 2005. Therefore, the reported results for 2006 did not include any activity for the Personal Computing Division, while the results for 2005 included four months of activity. This lack of comparable periods had a material impact on the company’s reported revenue growth.

Revenue growth and continued operational improvement in the Microelectronics business.

Total revenue, as reported, increased 0.3 percent (flat adjusted for currency) versus 2005. From a geographic perspective, as-reported revenue performance was mixed in 2006 compared to 2005, with growth in the Americas and EMEA, being offset by decreased revenue
in Asia Pacific.

OEM revenue increased 17.9 percent (18 percent adjusted for currency) in 2006 driven by strong demand for game processors in the Microelectronics business.

The company believes that a more appropriate revenue analysis is one that excludes the revenue results of the Personal Computing Division in 2005 because it presents results on a comparable basis and provides a more meaningful focus on the company’s ongoing operational performance.

For the year, the company benefited from solid contributions from the emerging countries of Brazil, Russia, India and China. Collectively, revenue from these four countries increased 20.5 percent
(16 percent adjusted for currency) in 2006 versus 2005.

The following is an analysis of the reportable segment results for Global Services, Systems and Technology and Software. The Global Financing segment analysis is included in the “Global Financing” section.

Global Services

($ in millions)

For the year ended December 31:

2006

2005

Yr.-To-Yr.Change

Global Services revenue:

$ 48,291

$ 47,407

1.9%

Global Technology Services

$ 32,322

$ 31,501

2.6%

Strategic Outsourcing

17,044

16,522

3.2

Integrated Technology Services

7,448

7,538

(1.2)

Maintenance

5,986

5,868

2.0

Business Transformation Outsourcing

1,845

1,573

17.2

Global Business Services

$ 15,969

$ 15,906

0.4%

GTS revenue increased 2.6 percent (2 percent adjusted for currency). SO revenue increased 3.2 percent due primarily to signings growth in 2005 and a continued focus on increasing sales in existing accounts. ITS revenue decreased 1.2 percent. The rate of revenue growth in ITS improved during the second half of 2006 reflecting progress from the changes implemented throughout the year to improve the business, including streamlining offerings and aligning skills to address higher growth and higher value areas. The acquisition of ISS, added to the company’s capabilities in security and intrusion protection
and contributed to improved performance in the fourth quarter of 2006. BTO revenue increased 17.2 percent. Maintenance revenue increased 2.0 percent driven by increased availability services on non-IBM IT equipment, primarily in the Americas and Asia Pacific.

GBS revenue increased 0.4 percent (1 percent adjusted for currency).
The rate of year-over-year revenue growth in GBS increased in the second half of 2006 reflecting progress made on actions taken throughout the year that focused on operational transformation and profitable growth initiatives.

($ in millions)

For the year ended December 31:

2006

2005

Yr.-To-Yr.Change

Global Services gross profit:

Global Technology Services:

Gross profit

$ 9,623

$ 9,226

4.3%

Gross profit margin

29.8%

29.3%

0.5 pts.

Global Business Services:

Gross profit

$ 3,694

$ 3,088

19.6%

Gross profit margin

23.1%

19.4%

3.7 pts.

The GTS segment pre-tax margin was 9.6 percent, an increase of 1.9 points versus 2005. This increase and the gross margin increase were driven by productivity initiatives and cost efficiencies, including
benefits from the targeted restructuring action in the second quarter of 2005.

GBS gross profit increased 19.6 percent to $3.7 billion and gross margin improved 3.7 points versus 2005. The segment pre-tax margin
was 9.8 percent, an improvement of 5.3 points versus 2005.
In addition to the benefit received from the incremental restructuring
in the second quarter of 2005, the margin improvements were driven by improved utilization, better contract management and stable-to-improved pricing.

Systems and Technology

($ in millions)

For the year ended December 31:

2006

2005

Yr.-To-Yr.Change

Systems and Technology revenue:

$ 21,970

$ 20,981

4.7%

System z

7.8%

System i

(15.0)

System p

(1.1)

System x

3.7

System Storage

6.4

Microelectronics

21.9

Engineering & Technology Services

(16.2)

Retail Store Solutions

21.4

Printing Systems

(7.6)

Systems and Technology revenue increased 4.7 percent (4 percent adjusted for currency) in 2006 versus 2005. System z revenue increased 7.8 percent reflecting continued strong customer acceptance of both specialty engines for Linux and Java workloads and traditional mainframe
workloads. MIPS shipments increased 11 percent versus 2005. System x revenue increased 3.7 percent driven by increased server revenue (5.3 percent) and System x blades growth of 22.3 percent. Although System p revenue declined 1.1 percent for the year, high-end server revenue increased 9.4 percent. In the third quarter of 2006, the company completed its transition to POWER5+ and expanded the implementation of POWER Quadcore technology to all POWER-based entry level System p products. System i revenue declined 15.0 percent as the company completed its transition to POWER5+ in the third quarter of 2006, however clients continued to leverage their existing capacity.

Key Branded Middleware revenue increased 17.1 percent, reflecting
continued momentum and benefit from sales and development investments along with additional benefit from acquisitions.

Revenue from the WebSphere family of products increased 23.3 percent and was led by double-digit growth in WebSphere Application Servers (25.3 percent) and WebSphere Business Integration (22.7 percent) software.

Information Management revenue increased 14.0 percent. Growth was driven by the Information on Demand portfolio of software products. The acquisition of FileNet Corporation, during the fourth quarter of 2006, also contributed to the growth.

Lotus revenue increased 12.0 percent driven by the Notes/Domino family of collaboration products.

Tivoli revenue increased 26.3 percent with double-digit growth in each of its key segments: Systems Management (24.5 percent), Security (40.8 percent) and Storage (27.4 percent). The 2006 acquisitions
of Micromuse, Inc. in the first quarter and MRO Software, Inc. in the fourth quarter added to the Tivoli brand capabilities and contributed
to the revenue growth.

Rational revenue increased 4.4 percent in 2006 versus 2005, in a
slower growing market. Revenue from Other Middleware products declined 0.6 percent in 2006. This product set includes more mature products which provide a more stable flow of revenue.

Operating Systems revenue declined 6.3 percent. The decline in revenue was primarily driven by improved price performance in System z operating systems. PLM revenue increased 4.2 percent. This product set benefited from a number of large transactions in the second quarter of 2006.

($ in millions)

For the year ended December 31:

2006

2005

Yr.-To-Yr.Change

Software gross profit:

Gross profit

$ 15,471

$ 14,296

8.2%

Gross profit margin

85.2%

84.9%

0.2 pts.

The increase in Software gross profit dollars and gross profit margin was primarily driven by the growth in Software revenue.

Global Financing

See the “Global Financing” section for a discussion of Global Financing’s revenue and
gross profit.

Total Expense and Other Income

Total expense and other income increased 2.8 percent versus 2005. Overall, the increase was primarily due to increased Research, development
and engineering expense driven by acquisitions and lower Other (income) and expense income driven by the gains associated with the sale of the Personal Computing business and the Microsoft Corporation settlement in 2005. Those increases were partially offset by lower SG&A expense due primarily to the restructuring charges recorded in the second quarter of 2005.The expense-to-revenue ratio increased 0.7 points to 27.3 percent in 2006, as revenue increased 0.3 percent and expense increased 2.8 percent in 2006 versus 2005.

Total SG&A expense of $20,259 million decreased 4.9 percent versus 2005. The decrease was primarily driven by the restructuring charges recorded in the second quarter of 2005. In addition, retirement-related expense and stock-based compensation decreased versus 2005. Those decreases were partially offset by increased operational expenses as a result of strategic acquisitions and investments in the software and services businesses as well as emerging countries.

Other (income) and expense was income of $766 million and $2,122 million in 2006 and 2005, respectively. The decrease in income was primarily driven by the $1,108 million pre-tax gain on the sale of the Personal Computing business in 2005. In addition, the company settled certain antitrust issues with the Microsoft Corporation in 2005 and the gain from this settlement was $775 million. Income from certain real estate activities decreased year to year, as 2005 had unusually large gains from a few transactions. Partially offsetting those decreases were additional Interest income; foreign currency transaction gains in 2006 versus losses in 2005 and real estate related restructuring charges recorded in the second quarter of 2005.

RD&E expense of $6,107 million increased 4.5 percent primarily driven by acquisitions and investments to maintain technology leadership
across the product offerings. Software spending increased $210 million and Systems and Technology spending increased $92 million in 2006 versus 2005. These increases were partially offset by the year-to-year reduction in Personal Computing of $52 million due to the divestiture of that business in 2005.

Intellectual property and custom development income of $900 million decreased $48 million or 5.0 percent versus 2005. There were no significant IP transactions in 2006 and 2005.

Interest expense of $278 million increased $58 million, or 26.6 percent in 2006, primarily driven by higher effective interest rates year to year.

Income Taxes

The provision for income taxes resulted in an effective tax rate of 29.3 percent for 2006, compared with the 2005 effective tax rate of 34.6 percent. The 5.3 point improvement in the tax rate was driven by the absence of the foreign earnings repatriation-related tax charge recorded in the third quarter of 2005 (4.3 points) as well as a benefit from the fourth-quarter 2006 settlement of the U.S. federal income tax audit for the years 2001 through 2003 (3.0 points). Those benefits were partially offset by a one-time tax cost associated with the 2006 intercompany transfer of certain intellectual property (4.3 points).

Financial Position

Total assets of $103,234 million declined $2,514 million ($6,223 million
adjusted for currency) primarily due to lower prepaid pension assets and a decrease in Cash and cash equivalents. These decreases were partially offset by increases in Goodwill, long-term deferred tax assets, Marketable Securities, trade receivables, financing receivables and Intangible Assets.

Total liabilities of $74,728 million increased $2,078 million (down $362 million adjusted for currency) primarily driven by Compensation and benefits, Deferred income and Accounts payable. Partially offsetting
those increases were decreases in long-term deferred tax and restructuring liabilities.

Stockholders’ equity decreased $4,592 million to $28,506 million primarily driven by retirement-related charges and net common stock transactions, partially offset by increased Retained earnings. The retirement-related driven decrease in Stockholders’ equity and the decrease in prepaid pension assets were a result of the adoption of SFAS No. 158 in 2006.

The company generated $15,019 million in cash flow provided by operating activities, an increase of $105 million compared to 2005. The increase was primarily driven by increased Net income ($1,559 million), lower pension funding in 2006 ($549 million) and an increase in cash driven by Accounts payable ($891 million) primarily resulting from the divestiture of the Personal Computing business in 2005. These increases were partially offset by growth in accounts receivable ($2,731 million) primarily driven by asset growth in Global Financing and a decrease in cash related to deferred income taxes ($461 million), due to utilization of tax credit carryforwards in 2005. Net cash used in investing increased $7,126 million versus 2005 primarily due to net purchases of marketable securities and other investments ($2,668 million), increased spending on acquisitions ($2,316 million), increased net capital spending ($1,210 million) and a decline in divestiture-related cash proceeds ($932 million). Net cash used in financing activities increased $1,057 million primarily due to higher dividend payments ($434 million) and increased net cash used to retire debt ($730 million).